Factor investing also works with Chinese A-shares

24-08-2017 | Interview

Many characteristics set A-shares apart from other equities. But does that mean that the major
anomalies that underpin
factor investing do not apply to mainland China’s stock markets? Well they do, even though there are differences owing to specific structural features of these markets. In fact, when designed appropriately, factor investing works pretty well with A-shares, says Weili Zhou, a quant researcher at Robeco.

Why did Robeco engage in researching factors in A-shares?

“Chinese A-shares offer considerable potential for investors. Although the Shanghai and Shenzhen stock exchanges were re-established only in 1990, the market capitalization of companies listed on these venues has grown extremely rapidly. The total A-share stock market has become the second largest in the world.”

“Although interest in factor investing in these markets is growing rapidly, relatively little research has been carried out and published on the subject. Robeco was actually a pioneer in this field. Back in 2008, we already found evidence that our emerging markets stock selection model also has predictive power in this market. We consider A-shares to be a good testing ground for factors, especially since these markets are not integrated and ownership patterns are clearly different. The majority of Chinese stocks are owned and traded directly by individual investors, while for the US it is the other way around.”

A-shares are good testing ground for factors, especially since these markets are not integrated and ownership patterns are clearly different

Are there any differences in the way factors behave with A-shares compared with other markets?

“In our most recent assessment, we focused on finding evidence of factor premiums in A-share markets recorded between 2000 and 2016 and using the definitions applied by Robeco to each one of the different factors we exploit. In this context, low volatility showed strong and robust risk-adjusted performance, while value and quality also showed good predictive power in differentiating future winners from losers. For momentum, though, the results were a bit mixed.”

“We found that while some of the criteria we use to measure momentum, for example revisions of analysts’ earnings forecasts, showed strong predicting power, as expected, while others such as medium-term price movement trends proved less effective. It seems that Chinese investors often overreact to news and then pull themselves back together again, resulting in frequent price reversals. Interestingly, however, we also found that our momentum ‘residualization’ technique, which enables us to focus on stocks with good intrinsic momentum, still proved effective.”

Could you comment on the strong low volatility anomaly in this market?

“Our findings suggest that the low volatility anomaly is fairly strong for A-shares. The annualized return dispersion between the top (low volatility) and bottom (high volatility) decile of stocks sorted based on 3-year volatility is more than 10%. To a certain extent, I think this could be attributed to the nature of Chinese investors. More than 80% of market participants are individuals, who tend to be less patient, more short term-oriented, compared to institutional investors. Until recently, they also tended to be heavily leveraged. At the same time, we observe that average turnover and volatility are considerably higher in the A-share market than in other major stock markets despite the fact that trading costs are relatively expensive.”

“These elements reinforce two of the most frequently heard explanations for the low volatility effect: the ‘lottery tickets’ and the ‘winner’s curse’ effects. The first theory assumes investors tend to overpay highly volatile stocks because they are attracted by their option-like payoff, just as they would be to lottery tickets. Meanwhile, the second explanation is that investors tend to overpay for stocks when they lack precise information about the company or the security itself. This phenomenon applies more to highly volatile stocks than to those with lower volatility.

“The behavior of Chinese investors also has consequences for other anomalies. For example, it also probably explains why medium-term momentum strategies do not work so well with A-shares, while enhancement can be found if we differentiate overreaction from underreaction”

What are the challenges for quant investing in China?

“First and foremost, the quality and coverage of the historical database. One example of a potential issue is backdoor listings. This term is used when a firm that may not qualify for a public offering process purchases one that is publicly-traded and uses it as a shell company. Backdoor listings have also been used to bypass general bans on IPOs. Over 120 cases have been reported over the 2014-2016 period. As a result, an apparel company can turn into a logistics group overnight. Likewise, a cheap low risk stock can become an expensive high risk one.”

“Chinese A-shares also tend to be more frequently suspended, often due to systematic market shocks. The impact of suspension should be handled carefully in any historical simulation, in order to detect whether a company has a low volatility due to ‘low risk’ or ‘no trade’, for example. Dealing appropriately with suspended stocks in a portfolio is another important issue.”

“Last but not least, the A-share database may record financial report figures which are supposedly ‘correct’, but which are actually forged. In the H-shares market, we have witnessed a few cases of fraud leading to either suspension or price crashes.

“All these issues attest to the need for tight human oversight and strict due diligence criteria, in addition to the rules-based investment process. When you have a stock in your portfolio or you are about to buy one, it is important to follow it closely. At Robeco, our quant portfolio managers have abundant experience in cooperating closely with fundamental colleagues to ensure this oversight is performed properly.”

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